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A Hayekian Hangover

In an attempt to side-step the political fallout from the recent
stock market sell-off, George W. Bush told us that we were
suffering from a hangover caused by the economic follies of the
1990s. While this was nothing more than a crude attempt to get the
monkey off his back, it contains more than a grain of truth.

What the economy is suffering from is a Hayekian hangover.
Friedrich von Hayek and other members of the Austrian School of
Economics developed a comprehensive theory of the business cycle
early last century. It reached a pinnacle in 1930-31, when Prof.
Hayek delivered his famous lectures at the London School of
Economics. Unfortunately, with the publication of Keynes’
General Theory in 1936, Austrian cycle theory went out
with the Keynesian tide. Austrian theory is in the process of being
restored to its former sterling status, however. Indeed, it now
receives a serious hearing, even in certain central banking
circles. For example, in recent years, the Bank for International
Settlements in Basel, Switzerland has repeatedly warned that the
U.S. economy is in the grips of a classic Austrian business cycle.
Accordingly, to comprehend where the economy has been and
anticipate its future course, an understanding of Hayek and the
Austrians is necessary.

For the Austrians, things go wrong when a central bank sets
short-term interest rates too low and allows credit to artificially
expand. Interest rates that are too low-lower than those that would
be set in a free market-induce businesses to discount the future at
artificially low rates. This pumps up the value of long-lived
investments and generates an investment-led boom, one that is
characterized by too much investment and investment that is biased
towards projects that are too long-lived and too capital
intensive.

An investment-led boom sows the seeds of its own destruction and
is unsustainable, however. Indeed, on the eve of the downturn
investors find that the loanable funds for investments are too
expensive to justify commitments they made during the preceding
monetary expansion. Some businesses engage in distress borrowing,
profit margins collapse under the weight of too much costly debt,
and-if that is not bad enough-many businesses are saddled with
excess capacity, resulting from what turned out to be wrong-headed
investment decisions. With that, the investment-driven boom turns
into a bust. In short, artificially-created investment booms always
end badly.

At present, the manifestations of a boom-bust episode litter the
economic landscape. Bankruptcies are on the rise, with WorldCom
representing the most spectacular example. In addition, many
investment projects have been abandoned or curtailed. For example,
a July 19th front page story in the Financial Times
reported that the Securities Industry Association, an umbrella
organization of investment banks and brokers, postponed an $8
billion investment to modernize markets.

A Hayekian hangover will vary in its duration and intensity,
depending on the degree of the preceding
over-investment/malinvestment binge, as well as the state of
confidence that accompanies the downturn or hangover phase of the
cycle. During this phase, a central bank’s attempts to restart the
economy by pushing interest rates down will-contrary to orthodox
economic doctrine-only delay the required capital restructuring
process and prolong the hangover.

If this hangover phase-working off excess capacity and
transforming the capital structure to shorten the length of
production processes-is not bad enough, the economy is vulnerable
during this phase to what Austrians termed a “secondary deflation.”
If a general feeling of insecurity and pessimism grips individuals
and enterprises during a Hayekian hangover, risk aversion and a
struggle for liquidity (cash reserves) will ensue. To build
liquidity, banks will call in loans and/or not be as willing to
extend credit. Not surprisingly, banks are already scrambling for
liquidity. During the past 17 months, banks have been cutting back
on corporate lending, shunning especially industries like energy,
textiles, steel and telecommunications that over-invested during
the boom. Moreover, banks are charging higher rates and bigger
up-front fees on most other loans, even to top-rated companies.
Households, too, are liquidating assets to increase their cash
positions and pay down debts. Indeed, they pulled $13.8 billion out
of U.S. equity mutual funds in June. This scramble for liquidity
will put a further damper on investment as well as consumption.

Several aspects of a secondary deflation are worthy of further
comment. If the forces of a secondary deflation are strong enough,
a central bank’s liquidity injections can be rendered ineffective
by what amounts to private sector sterilization. When people expect
falling prices and a real deflation, their demand for cash will
increase, soaking up liquidity injections. This has been the recent
experience in Japan, where prices continue to fall in the face of
year-over-year base money and yen note (cash) growth rates of 30
and 15 percent, respectively. While milder forms of a so-called
secondary deflation don’t result in real deflations, they do
undermine economic growth and extend the life of Hayekian
hangovers.

Even though the primary cause of a downturn is an
over-investment boom, understood in the Austrian sense, Hayek
acknowledged that a secondary deflation could ensue and that it
could be best understood in Keynesian terms. This is particularly
relevant in the current US context. Prof. Wynne Godley of Cambridge
University made this perfectly clear in a July 16th letter to the
Financial Times. He noted that in the first quarter of
2002, the household sector of the economy was in deficit by 2
percent of disposable income. Such a deficit, which is unusual, can
be financed either by borrowing or by selling assets. With the
sinking stock market, high debt ratios, and the current state of
confidence, people could easily decide that it is time to put their
financial affairs in order. If households’ net savings were to
revert to their long-term norms, personal consumption, according to
Prof. Godley’s calculations, would fall relative to income by 6
percent. In consequence, consumption, which has been holding the
economy’s head above water, would sink as investment has already
done.

The U.S. is already in the grips of a Hayekian hangover and the
seeds of a secondary deflation are threatening to sprout. Two
factors make the threat of a secondary deflation more likely with
each passing day: the war on corporate America and the war on
terrorism. Past corporate shenanigans continue to be uncovered with
alarming regularity. In response, the Congress, in a fit of
demagoguery, has declared war on corporate America. This has
further panicked investors, shattered confidence, increased risk
aversion and set off a scramble for liquidity.

Will Washington’s warriors, armed with new legislation and
regulations, put a stop to corporate malfeasance? Probably not.
After all, the Securities and Exchange Commission has been around
since 1934, and as Prof. George Stigler of the University of
Chicago has convincingly shown, it has failed to have much effect
on the flamboyant falsehoods that on occasion appear in
prospectuses and company accounts. If Congress is serious about
protecting investors and rooting out malfeasant corporate
executives, it should remove the impediments and lower the costs of
mounting hostile takeovers by repealing the Williams Act of 1968.
The threat of hostile takeovers (more competition) is the only way
to remove the protective cocoons that envelop corporate crooks and
incompetents.

Perhaps the most underrated factor undermining confidence is the
war on terrorism. Among other things, the war effort has diverted
the Bush administration’s attention away from virtually all things
economic. In consequence, the administration does not have a
consistent and plausible economic game plan. And without a game
plan, economic confidence suffers.

In addition, there are longer-term consequences. The U.S. is
engaged in a war with an elusive enemy and a very uncertain
outcome. The only certainties are that this war, as it is being
prosecuted, will have a very long duration and will consume
meaningful resources. The diversion of those resources toward a war
effort will be a drag on the economy.

The medium-term (approximately the next five years) economic
consequences of the war on terrorism are analyzed in a recent
study, “Economic Consequences of Terrorism,” published by the
Organization for Economic Cooperation and Development (OECD) in
Paris. According to the OECD, the war will affect the international
economy through three primary channels: a transformation of the
insurance industry, depressed trade due to higher transportation
costs, and increased government spending on security. It is
important to stress that the OECD study is ultra-conservative.
Specifically, it assumes that there will be no further terrorist
success stories and that there will be no pre-emptive strikes
against the likes of Saddam Hussein.

The insurance industry suffered windfall losses estimated at
$30-58 billion from the September 11 terrorist attacks on the U.S.
Even though no insurers were forced into bankruptcy, their capital
bases took a big hit and many saw their solvency ratios go to
extremely dangerous levels. In consequence, insurers have reduced
their coverage and raised premiums by 30 percent on average, with
potential target structures such as chemical and power plants and
“iconic” office buildings paying even more.

Many insurers used the terrorist attacks to rationalize
government intervention and government assistance. Some
countries-such as Spain, the UK, France, South Africa, and
Israel-have already introduced government mechanisms to insure
against the risk of terrorism. Though these interventions were
introduced as temporary measures to be subsumed by the private
sector at a later date, many have persisted well beyond their
original mandates. In this vein, the United States has proposed a
“Terrorism Risk Insurance Act” to absorb excessive losses for the
insurance industry. That bill has been read twice in the Senate and
referred to the Committee on Banking, Housing and Urban
Affairs.

International trade will suffer due to increases in
transportation costs. The fear of a terrorist incursion through
porous (i.e., trade-friendly) borders has resulted in demands for
additional checks and searches at ports and land borders. Thus,
“compliance costs”-the cost of collecting, producing, transmitting
and processing required information and documents-will likely
increase by 1 to 3 percent of the value of traded goods, up from
their current levels of 5 to 13 percent. Since international trade
is quite sensitive to increases in transportation costs-the
elasticity of trade flows with respect to transportation costs is
estimated at -2 to -3, meaning that a 1 percent increase in the
cost of trading internationally reduces trade flows by 2-3
percent-the war on terrorism promises to put a big drag on
international trade.

In addition, delays in shipments and other distortions to trade
flows resulting from new regulations will disrupt just-in-time
supply chain management techniques developed over the past decade.
As a precaution against interruptions in the supply chain, firms
may begin to carry larger inventories, requiring new infusions of
working capital. If inventories climb to their “pre-just-in-time”
levels, the additional carrying cost is expected to reach 0.7
percent of US GDP.

Increased defense spending is also a foregone conclusion.
According to the OECD, higher levels of government spending will
erode the post-Cold War “peace dividend” and impact the economy
through three channels. First, since increased military spending
will most likely be financed through new debt issuance, long-term
interest rates will rise. Second, reallocating capital from the
private sector to the public sector will reduce labor productivity.
Third, the trend of fiscal consolidation observed since the end of
the Cold War is likely to be undermined, leading to negative
impacts on long-term expectations.

If you add the lack of a U.S. economic game plan, the war on
corporate America and the war on terrorism to a Hayekian hangover
and the precarious state of corporate and household confidence and
finances, you have the increasing likelihood of a secondary
deflation and a double-dip. And if that short-term prospect isn’t
gloomy enough, consider what promises to be the legacy of George W.
Bush’s first term: a ballooning of the modern regulatory state, one
that will far surpass the dreadful deeds inflicted during the Nixon
years. For a sobering account of where that will lead us, there is
nothing better than Prof. Hayek’s 1944 classic, The Road to
Serfdom.

This article was published in Friedberg’s Commodity and
Currency Comments, v. 23, no. 4, July 29, 2002. The original
version was presented as the Inaugural Friedrich von Hayek Lecture,
The International Life & Annuities Forum, Southampton, Bermuda,
June 26, 2002.